Sunday, April 17, 2011

Perception is Reality in Oil Prices

My previous post on the reasons for the increasing price of oil may be unsatisfying to some. You will note that a number of the reasons are because of what could happen, not because of what has actually happened.

The reason what could happen affects the price is because markets are always forward looking. If something will happen in the future, it will be reflected in the price today. Similarly, if something could happen, it will also be reflected in today's price, but perhaps at a discount.

In non-renewable natural resources the future is reflected in what is called the Marginal User Cost. This is the opportunity cost we pay today for using a unit of a resource today rather than having it available to consume in the future. If supplies in the future will be lower, MUC increases. Similarly, if supplies in the future might be lower, MUC increases.

On the flip side, if future supplies are thought to be plentiful, MUC may go to zero leaving the price equal to the marginal extraction cost.

For further explanation, see my earlier post on MUC when oil prices were falling.

In short, the market's perception of the future changes the price today.

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